Commodity traders have a mutual interest in improving the overall risk perception of their sector and its practices. It is also important to understand what’s driving the banks’ lending decisions, says Mihai Andreoiu, Senior Director at Redbridge.
In a world in which the client is king, bankers have several reasons to worry. Let’s consider the relationship between a bank and a trading company. In such a relationship, flexibility, pricing and, most importantly in the world of commodity trading, the speed of reaction are key. A trading company needs that letter of credit issued or open account purchase financed the next day.
And if a bank’s processing times are not in line with expectations, the trading company will without any doubt pass on less business to that bank. And it will do the same if the bank is too expensive or does not provide enough flexibility. What’s more, risk considerations, including compliance, can make or break a relationship. There is a structural and regulatory need for financial institutions to understand the risks they take in order to reach the optimal (credit) decisions and correctly represent the various risks taken in their pricing models.
However – and this is a surprise in an environment of abundant liquidity – trading companies are at least, if not more, worried about their banks. To many of these firms, the bank is the real king.
It is true that trading firms are not always the most straightforward clients. Transparency is not the rule. Ups and downs are frequent. And sanction driven regulations are raising further concerns among the banks. The relationship between trading firms and their funding partners is symbiotic by nature. The working capital needs of the commodity trading sector are unrivaled after two decades of, overall, high commodity prices. Traders are the brains. Banks represent the muscles by providing the financing.
Improving overall risk perception
So against this backdrop, what can commodity traders do so that they don’t need to fear their banks and to mitigate the concerns of their financing partners? First, it is crucial to bear in mind that each player is unique, but the fundamentals of risk perception are the same for everyone.
Commodity traders have a mutual interest in improving the overall risk perception of their sector and its practices. Some of the ‘Big Boys’ have taken a leadership role by voluntarily publishing their financial statements and risk practices in a sector that is fundamentally dominated by private information. Unfortunately, this path is not open to everyone. Smaller traders need to keep their cards close to their chests and away from their competitors’ eyes if they want to stay in the game.
Regardless of size, commodity and region, it is important to understand what drives the banks’ lending decisions. How does a banker perceive risk? How does this understanding translate into a borrower risk rating / probability of default (PD), or into a transaction risk rating / loss given default (LGD)? What’s more, being able to evaluate the profitability of an overall relationship is vital when negotiating with a bank.
Several qualitative elements can enhance a borrower’s risk rating. These include, for example, a statement on the firm’s risk management policy and strategy, and disclosures about hedging practices, trades and positions. Typically, greater transparency translates into lower lending margins as the lender is better able to evaluate the risk of its asset. Similarly, the type of financing provided and the risk mitigation surrounding it (such as security, evidence, title, control) will be reflected in the LGD rate. Credit risk models differ from one bank to another, but actively trying to improve the risk profile is a step in the right direction.
What remains striking for commodity trading firms is the range of pricing and related practices they are subject to. How often, if a pricing arrangement has been agreed for a credit line, is it not touched for years? This means that pricing structures that are no longer in line with market practice can remain in place for years. Should the risk of the borrower and transaction be quantified into a margin only, or should there be additional fees based on factors such as nominal amounts and tonnage charged for certain transactions? And we’re not even talking about syndicated facilities, for which fees have specific roles, but old-fashioned bilateral transactional lines.
In this context, seeking clarity on the fees paid to banks (interest, fees, commissions) is another vital factor. Coupling this information with the credit rating means it is possible to calculate the profitability of a banking relationship. Doing so enables commodity traders to manage their banking relationships and focus on the main aspects that ultimately drive the financiers’ flexibility and pricing.